A Second Best Response to Inefficient Tax and Entitlement Policies

Miles Kimball, an economist from the University of Michigan, blogged last week about his idea for turning the economy around: “Federal Lines of Credit” or FLOCs. A FLOC is a government issued credit card with a line of credit of $2,000 per taxpayer ($4,000 per couple). Money spent using the credit card would be paid back through higher Federal withholding taxes over the next five or ten years. Kimball argues that FLOCs can deliver the biggest bang for the buck in fiscal policy. Although Reihan Salam of the National Review Online called FLOCs “an intriguing idea” there may be better ways to address the problems that FLOCs are designed to solve.

The idea behind FLOCs is that many working class households are credit-constrained and unable to smooth consumption when their income drops in an economic downturn. These households reduce consumption in response to a temporary decline in income because of capital market imperfections and their inability to borrow out of future earnings. They would spend more, raise aggregate demand and improve our weak recovery if they could borrow at lower interest rates.

A FLOC is a new government program designed to mitigate the impact of credit constraints by directly lending to households. Working class households are credit-constrained because so little of their wealth is held in financial assets. Part of this problem is due to our tax and entitlement policies. Our tax code encourages wealth accumulation through home ownership instead of financial assets; retirement savings are directed into the social security system, IRAs, 401ks, and company pension plans. Our tax code also penalizes workers for drawing down these assets to smooth consumption during economic downturns.

If the U.S. had a consumption tax, rather than an income tax, households would be encouraged to save more and fewer would be credit-constrained. If the social security system were replaced with individual retirement accounts, where individuals could withdraw a portion of their accumulated assets or at least borrow against them, fewer households would be credit-constrained. Households would respond to a job loss or reduction in the length of their workweek by drawing down the assets they had saved for a rainy day and consumption and aggregate demand would not fall as much. Taxes would be paid on funds withdrawn from savings and retirement accounts but no additional penalties would be imposed.

Most middle aged and older workers have contributed a substantial amount to retirement plans that can’t easily be used to smooth consumption. There are over 5 million unemployed workers who are age 40 and above. Many of these workers contributed many tens of thousands of dollars into the social security system, an IRA, a 401k plan, or their pension fund. Why introduce a new government program so that these households can borrow $2,000 to $4,000 from the Federal government? Let these workers borrow against their own accumulated assets. Better yet, reform these programs and the tax code so that workers are given a greater incentive to save and are not penalized for smoothing consumption.

A tax code that encourages saving and doesn’t penalize dissaving to smooth consumption and an entitlement system based on individual retirement accounts will encourage more consumption smoothing in recessions. Smarter tax and entitlement policies will not eliminate capital market imperfections so there may still be a reason to consider FLOCs for younger workers. I would like to see Miles Kimball, a self-proclaimed supply side liberal, advocate comprehensive tax and entitlement reform so that more households have better opportunities to maintain higher consumption levels through tough economic times.